Bogleheads® Conference 2013 - Panel of Experts I
00:00:00.000 | [ Silence ]
00:00:14.000 | [ Applause ]
00:00:15.760 | >> Okay, in alphabetical order,
00:00:17.960 | I'd like to introduce the panel members.
00:00:20.360 | You all have the long bios in your welcome kit,
00:00:24.440 | but at the same time, I'm going to do just short introductions.
00:00:28.440 | First of all, our first panelist is co-founder
00:00:31.360 | of Efficient Frontier Advisors and author
00:00:34.000 | of several successful titles on finance and economic history.
00:00:38.080 | Please welcome our real vocal
00:00:39.400 | and favorite, Dr. Bill Bernstein.
00:00:41.960 | [ Applause ]
00:00:48.120 | Our next panelist is the founder
00:00:50.160 | of the low-cost investment management firm,
00:00:52.560 | Portfolio Solutions, author of six investment-related books,
00:00:57.200 | Forbes.com columnist,
00:00:58.880 | and a Wall Street Journal Experts contributor.
00:01:01.320 | Please welcome Rick Ferry.
00:01:03.440 | [ Applause ]
00:01:08.840 | Our next panelist is the founder of WealthLogic.
00:01:11.520 | He's an author, and he writes for CBS Money Watch
00:01:14.240 | and other publications.
00:01:15.760 | Please welcome Alan Roth.
00:01:18.440 | [ Applause ]
00:01:23.040 | Our final panel, our next panelist is a retired former
00:01:26.600 | chief investment officer at Vanguard.
00:01:28.360 | He now serves as a senior consultant to Vanguard.
00:01:30.880 | Please welcome Gus Salter.
00:01:32.600 | [ Applause ]
00:01:37.280 | And our final panelist is -- who's not on the agenda,
00:01:40.840 | but is going to join us, is none other than the founder
00:01:45.200 | of Vanguard, Mr. Jack Bogle.
00:01:47.600 | [ Applause ]
00:01:54.360 | -This is my day to listen instead of talk.
00:01:56.800 | [ Laughter ]
00:01:58.520 | And they kind of conned me into being part of the panel,
00:02:02.320 | which I'm happy to do if they want.
00:02:03.920 | I think you will find probably quite a bit of silence from me.
00:02:08.720 | Quite a bit of silence from me.
00:02:10.800 | Can you hear me back there?
00:02:13.360 | Quite a bit of silence from me.
00:02:15.320 | That doesn't mean I'm not interested in what's going on.
00:02:17.200 | This is a terrific panel,
00:02:19.320 | and Gus has just been a huge asset ever since,
00:02:23.400 | I guess, September of 1987, and a good friend of mine.
00:02:28.360 | One of the best people around,
00:02:29.560 | as well as being a brilliant guy to run the index fund.
00:02:33.320 | A man filled with ideas, filled with convictions,
00:02:36.960 | filled with passion about the work he's doing.
00:02:39.200 | So I salute you, Gus, again for the job you did this morning.
00:02:42.720 | I actually wanted to be up here to make a quick announcement.
00:02:45.600 | I just haven't been able to get up since I sat down.
00:02:48.960 | That's why I'm on the panel.
00:02:50.360 | But a couple of things.
00:02:52.160 | One, I'm reminded of a story they tell
00:02:56.000 | about John Quincy Adams of his aging years, sick in bed.
00:03:02.000 | And a friend comes to see him, and he says,
00:03:04.560 | "How is John Quincy Adams today?"
00:03:07.760 | John Quincy Adams looks at him and says,
00:03:10.720 | "John Quincy Adams has never been better in his entire life.
00:03:15.520 | Things are wonderful.
00:03:17.160 | He's at the top of his game."
00:03:19.560 | However, the house to John Quincy Adams is falling down.
00:03:24.760 | [laughter]
00:03:27.360 | And that's the way I feel now.
00:03:29.760 | [laughter]
00:03:31.520 | 'Cause everything seems to be going wrong.
00:03:33.120 | I have to get out of here and get a CAT scan on my shoulder
00:03:35.760 | to see if there's something going on down there
00:03:37.120 | nobody knows about.
00:03:38.160 | So I will not be able to be here for the other panel.
00:03:43.200 | But I did want to just take this opportunity
00:03:45.000 | to thank you all so very much.
00:03:47.520 | I've had so many nice compliments.
00:03:52.000 | You're thanking me for things that any ordinary person
00:03:55.200 | would have done in the course of a long career.
00:03:58.400 | And I put myself in the ordinary category,
00:04:01.320 | but I did have a couple of good ideas.
00:04:03.600 | [laughter]
00:04:05.120 | And it turns out, world-changing ideas.
00:04:08.800 | In fact, just as Gus said,
00:04:11.200 | indexing is changing the world of investing.
00:04:13.920 | And so I feel very good to have been a part of that
00:04:15.800 | and even a leader.
00:04:17.200 | And on that point, by the way,
00:04:19.120 | I think it's okay for me to say this.
00:04:21.000 | I mentioned the other morning that I had written a letter
00:04:23.000 | to the editor of the "Wall Street Journal"
00:04:25.200 | telling him that the real Nobel laureate that influenced me
00:04:28.600 | was Paul Samuelson.
00:04:30.120 | But I'd never heard of Gene Fama.
00:04:32.000 | [laughter]
00:04:34.800 | At that time, at that time.
00:04:37.320 | And that Gene Fama's conviction was so great
00:04:43.120 | that he started his own--
00:04:44.560 | was that formation the inspiration for a fund group,
00:04:48.120 | but not an index fund group.
00:04:50.880 | He's a DFA guy.
00:04:52.960 | He believes that the markets,
00:04:54.720 | despite the efficient market hypothesis,
00:04:57.720 | please have permanent, persistent inefficiencies.
00:05:01.360 | So I had a little note from the guy.
00:05:04.160 | It's a long, long letter to the editor, very long.
00:05:08.160 | Most of them are 150, 200 words.
00:05:10.680 | This is almost 500.
00:05:12.520 | And when I got back to the office yesterday,
00:05:14.920 | I think I was there sometime--
00:05:16.240 | my yesterday was quite a--
00:05:18.040 | I got back home from New York.
00:05:19.520 | You can probably see that safely.
00:05:21.440 | But they're going to publish it tomorrow.
00:05:24.520 | Or they say they are.
00:05:25.920 | [laughter]
00:05:28.040 | Count on nothing.
00:05:29.040 | I mean, this is well-intentioned.
00:05:31.240 | Funny things happen on the way to the--
00:05:34.120 | getting on to the journal op-ed page.
00:05:37.120 | And so we'll see if they publish it.
00:05:39.040 | But that's just a clue.
00:05:40.320 | I'll put it on the Global Heads website on Monday,
00:05:44.040 | because this weekend, I'm not going to work.
00:05:48.040 | [laughter]
00:05:50.040 | [applause]
00:05:55.040 | Two more things to say.
00:05:56.040 | I want us to thank Kevin for his loyalty
00:05:57.840 | over all those years.
00:05:59.440 | Couldn't have done it better, Kev.
00:06:00.440 | I see you back there.
00:06:01.440 | I know you're hiding.
00:06:02.440 | [applause]
00:06:07.440 | More than worthy, since you're dead.
00:06:09.440 | To Kevin.
00:06:10.440 | And we have kind of a good time around the office.
00:06:14.040 | I come in-- as I come in, you know,
00:06:16.040 | it's like the teacher coming into the classroom.
00:06:18.040 | And there are Mike and Sarah and Emily chatting up a storm
00:06:21.040 | and laughing.
00:06:22.040 | I come in, silence.
00:06:24.040 | [laughter]
00:06:26.040 | Here he comes.
00:06:27.040 | [laughter]
00:06:29.040 | And finally, if I can just say something
00:06:32.040 | that struck me about Bill Bernstein's remarks yesterday.
00:06:35.040 | And that is that I love some of the Jewish language expressions.
00:06:40.040 | I have a lot of very good friends, many from New York,
00:06:42.040 | who use these expressions all the time.
00:06:45.040 | So I talk about, like, the self-evident Jewish expression.
00:06:49.040 | Everybody-- you don't have to be told what it means
00:06:51.040 | when someone says, "He's a real schmuck."
00:06:53.040 | [laughter]
00:06:55.040 | Right?
00:06:56.040 | The first time I was called a mensch,
00:06:58.040 | which Bill called me the other day,
00:07:00.040 | I had no idea what he was talking about.
00:07:02.040 | [laughter]
00:07:04.040 | He said, "It means something better than a schmuck."
00:07:07.040 | [laughter]
00:07:11.040 | So thank you all.
00:07:13.040 | And that's probably the last you'll hear from me,
00:07:15.040 | so have a safe trip back.
00:07:17.040 | And I'll be on my way before the next panel takes place.
00:07:20.040 | So thank you again.
00:07:21.040 | [applause]
00:07:29.040 | One of the things we like to do,
00:07:31.040 | just in case you don't know it,
00:07:32.040 | is the panel members pay their own way,
00:07:34.040 | just like everybody else does.
00:07:36.040 | So one of the things we do, it's a non-commercial event,
00:07:39.040 | but we still let them plug the latest thing that they're doing.
00:07:42.040 | So I'd like to give everybody a chance
00:07:44.040 | to let us and the audience know what you're up to.
00:07:49.040 | Do you have a new book coming out?
00:07:51.040 | Have you done any papers?
00:07:53.040 | And Gus, I'm sure we'd love to hear what you're doing
00:07:55.040 | since you retired
00:07:57.040 | and how retirement life is agreeing with you.
00:08:00.040 | Can we go down the line?
00:08:01.040 | Rick, I heard you got a new book out,
00:08:04.040 | and I heard you recently did a white paper.
00:08:07.040 | So do you want to tell the people about those items?
00:08:12.040 | Sure.
00:08:13.040 | I published a white paper,
00:08:14.040 | if those of you who are interested,
00:08:15.040 | on my website, rickferry.com.
00:08:18.040 | And the white paper had to do with
00:08:21.040 | a case for index fund portfolios.
00:08:25.040 | We always look at index funds in each category of investing,
00:08:29.040 | and we look at the performance of an index fund,
00:08:31.040 | let's say an S&P 500,
00:08:33.040 | relative to large cap actively managed funds.
00:08:37.040 | We look at the performance of the Vanguard total bond market
00:08:41.040 | in relation to actively managed bond funds,
00:08:44.040 | and so forth in each category.
00:08:46.040 | And Vanguard does an excellent job with a white paper every year
00:08:49.040 | called "A Case for Index Funds"
00:08:51.040 | or "The Case for Index Funds,"
00:08:53.040 | where they look at each of these categories.
00:08:54.040 | But I thought it would be interesting
00:08:56.040 | to take multiple index funds from multiple categories
00:09:00.040 | and put them together in a portfolio,
00:09:03.040 | and then measure the performance of a portfolio of index funds
00:09:06.040 | relative to a portfolio
00:09:08.040 | or 5,000 randomly selected portfolios
00:09:11.040 | of actively managed funds in the same categories.
00:09:14.040 | So this study looks at the dynamics
00:09:17.040 | of how putting multiple index funds in a portfolio
00:09:21.040 | act relative to the individual asset classes
00:09:25.040 | and also how well the portfolio performs
00:09:28.040 | relative to a portfolio of randomly selected active funds.
00:09:31.040 | And some interesting things take place,
00:09:33.040 | which I can share later if you want or go through it now,
00:09:36.040 | but basically you get a--
00:09:38.040 | we call it a "portfolio multiplier."
00:09:41.040 | Things happen in a portfolio when you have all index funds
00:09:45.040 | that actually the probability of the portfolio
00:09:48.040 | outperforming actively managed funds
00:09:50.040 | actually increases to a fairly significant level
00:09:53.040 | depending on how many asset classes you put in
00:09:55.040 | over and above what each of the individual asset classes show.
00:09:59.040 | So it's kind of interesting work.
00:10:00.040 | I wanted to take indexing--
00:10:02.040 | at least the study of indexing--
00:10:04.040 | to a portfolio level,
00:10:05.040 | which has not really been looked at yet.
00:10:07.040 | In addition to that, right now I'm writing a book.
00:10:11.040 | And I started it last year,
00:10:14.040 | if some of you who are here remember.
00:10:16.040 | But it never materialized
00:10:19.040 | because I was having difficulty writing it,
00:10:21.040 | so I changed the name of the book
00:10:22.040 | and approached it from a different way.
00:10:24.040 | And you're all going to recognize this,
00:10:25.040 | but the title of the book is called
00:10:27.040 | "The Three-Fund Portfolio."
00:10:29.040 | [laughter]
00:10:31.040 | And what it is, though,
00:10:33.040 | it begins with what I'll briefly discuss here for a second,
00:10:37.040 | is we all have the same philosophy as Bogleheads.
00:10:41.040 | Everyone here in this room has the same philosophy.
00:10:44.040 | However, there are maybe 200 people in this room.
00:10:47.040 | I guarantee you none of us have the same portfolio.
00:10:51.040 | We all have different strategies.
00:10:53.040 | And your strategy is right for you.
00:10:55.040 | My strategy is right for me.
00:10:57.040 | I'm using the three-fund portfolio
00:10:59.040 | as the beginning strategy for everybody in the book.
00:11:02.040 | And the final part of being a successful passive investor
00:11:04.040 | is having the discipline to follow the strategy.
00:11:07.040 | And the only way you're going to have the discipline
00:11:09.040 | to follow the strategy
00:11:10.040 | is if you have the Boglehead philosophy.
00:11:12.040 | So that's what's going to be in the book.
00:11:14.040 | That's what I'm working on.
00:11:16.040 | [laughter]
00:11:18.040 | I would say retirement doesn't feel like retirement so far.
00:11:21.040 | [laughter]
00:11:23.040 | Not what I thought retirement was.
00:11:25.040 | But actually, I think I'm just moving on
00:11:27.040 | to doing something new for a change.
00:11:29.040 | At the end of last year, the very last thing I did at Viagra
00:11:32.040 | was to convince the firm to change equity benchmarks
00:11:36.040 | and then took off out the door and said,
00:11:38.040 | "You know, good luck implementing this."
00:11:40.040 | [laughter]
00:11:42.040 | So actually, I was retained to consult on that implementation process
00:11:46.040 | during the first five months of this year.
00:11:49.040 | I am continuing to do consulting for Vanguard,
00:11:53.040 | primarily speaking to clients and at symposiums.
00:11:58.040 | In addition to that, I'm talking with the university
00:12:01.040 | and will be picking up a role at a university
00:12:05.040 | that has not yet announced it
00:12:07.040 | probably about March or April of next year.
00:12:10.040 | So I've been in 68 airplanes this year,
00:12:13.040 | so I've been fairly busy.
00:12:15.040 | [laughter]
00:12:17.040 | I've pretty much achieved my life's goal,
00:12:20.040 | which is to be able to stay in my bathroom until 2 p.m.
00:12:23.040 | [laughter]
00:12:27.040 | and play with my grandchildren perfectly
00:12:30.040 | after I get out of my bathroom.
00:12:32.040 | And Jack gave me the opportunity to plug my e-book,
00:12:37.040 | so I'm not going to do that.
00:12:39.040 | The e-book that I've written and I'm proudest of
00:12:42.040 | is an article that was in FAJ called "The Paradox of Wealth."
00:12:45.040 | The bad news is you can't get it
00:12:47.040 | unless you have a subscription to FAJ,
00:12:49.040 | but the good news is there's a much better working version
00:12:52.040 | of it available, "The Paradox of Wealth,"
00:12:54.040 | on Larry Siegel's website, LarrySiegel.org.
00:12:57.040 | Just Google it. You'll find it. It's easy enough.
00:12:59.040 | It's a much better version because FAJ cut the heck out of these.
00:13:03.040 | It's called "The Paradox of Wealth,"
00:13:05.040 | and it's on Larry Siegel's website, LarrySiegel.org, I think.
00:13:09.040 | It's easy to find. If you can't find it,
00:13:11.040 | just e-mail me on wbinnovationprojector.com.
00:13:15.040 | And I'm casting around for new things to write about.
00:13:20.040 | I haven't really settled on anything yet.
00:13:24.040 | I may do another finance book.
00:13:26.040 | I may do another big-picture history book.
00:13:28.040 | I have no idea, but I'm sure having fun figuring it out.
00:13:33.040 | Like Bill, I've met my goal of being on a panel with these guys.
00:13:39.040 | I'll pay $500 for a picture, and we'll take our picture.
00:13:43.040 | Aside from my normal writing in "CBS Money Watch"
00:13:46.040 | and "Financial Planning Magazine"
00:13:48.040 | and "The Wall Street Journal Total Return Blog,"
00:13:51.040 | I've written a couple of important pieces coming out early next year
00:13:54.040 | in "AARP Magazine."
00:13:56.040 | And the one I'm most proud of really has little to do with investing.
00:14:00.040 | It's called "When the Numbers Stop Making Sense."
00:14:03.040 | How we protect ourselves later on in life
00:14:07.040 | if we no longer have our full thinking capacity,
00:14:14.040 | cognitive abilities, and can be tricked by other people.
00:14:18.040 | So certain things that we can do.
00:14:20.040 | And it ends up--it may be inevitable.
00:14:22.040 | Even the mind games, you know, Sudoku, crossword puzzles,
00:14:27.040 | may not slow things down.
00:14:31.040 | All right, well, we'll start with the Q&A,
00:14:34.040 | and Jack, it's good that you're here.
00:14:37.040 | Probably the most requested--the number one, the most questions I got
00:14:43.040 | was on a subject that's very controversial on the board of its own,
00:14:48.040 | and that's treating Social Security as a bond.
00:14:53.040 | So I'd like to--Jack has already touched on that yesterday,
00:14:58.040 | so I would like to get the panelists--the members to share their thoughts
00:15:05.040 | on treating Social Security as a bond
00:15:09.040 | and increasing their equity allocation as a result.
00:15:15.040 | Can we start with Alan, please?
00:15:18.040 | I think the mathematical answer is that Social Security is a bond,
00:15:22.040 | but we're not mathematical beings.
00:15:24.040 | We're emotional beings.
00:15:26.040 | So therefore, what I tend to do is look at the cash flow for a client
00:15:30.040 | that they need above and beyond Social Security
00:15:34.040 | and then design the portfolio that not only matches their willingness to take risk,
00:15:39.040 | but even more important, their need to take risk.
00:15:42.040 | Since we can't take the money with us when they leave,
00:15:45.040 | we may not even be on the efficient frontier.
00:15:47.040 | We may be on what minimizes the probability of outliving their money.
00:15:54.040 | You can do one of two things.
00:15:57.040 | You can either capitalize the Social Security as a bond,
00:16:03.040 | but then you can't include your Social Security payments in--
00:16:08.040 | or you have to include your--so you have to include--
00:16:12.040 | you can't include the stream in your living expenses.
00:16:15.040 | So if you're making $30,000 a year from Social Security
00:16:19.040 | and you need $70,000 a year to live,
00:16:22.040 | you cannot say, "I only need $40,000 a year," and capitalize it.
00:16:28.040 | You have to do one or the other.
00:16:30.040 | You either have to say, "I can capitalize it,"
00:16:32.040 | and then you have $70,000 a year in living expenses,
00:16:34.040 | or you can say, "I have $40,000 a year of residual living expenses
00:16:38.040 | after the Social Security comes in,"
00:16:40.040 | but then you can't capitalize the Social Security.
00:16:43.040 | One or the other can't include that spending.
00:16:46.040 | So I guess this presumes we're going to be able to collect Social Security.
00:16:50.040 | [laughter]
00:16:53.040 | You know, it's very much like a defined benefit plan,
00:16:56.040 | and I think Bill and Alan covered it.
00:17:00.040 | It's very similar to someone who receives deferred compensation,
00:17:07.040 | and I think with deferred comp, you need to figure out how that's invested
00:17:12.040 | and invest around it.
00:17:13.040 | So I think including it in your portfolio is the appropriate way to think about it.
00:17:22.040 | Social Security I treat as though you're--as pay.
00:17:28.040 | Just like a pension, it's pay.
00:17:30.040 | It doesn't really have a net present value because you can't sell it.
00:17:35.040 | You can't cash it in.
00:17:36.040 | You can't go to the Social Security office and say,
00:17:38.040 | "Well, the net present value of my Social Security is $300,000.
00:17:41.040 | Give me a check."
00:17:44.040 | It is like getting paid without working.
00:17:48.040 | When you die, it goes away.
00:17:51.040 | Your spouse doesn't get it.
00:17:55.040 | With Social Security, there are some partial payments.
00:17:58.040 | So I don't treat it as a bond.
00:18:01.040 | I look at it the way Bill described it actually a couple of years ago,
00:18:04.040 | and Alan described it a little bit earlier.
00:18:06.040 | You look at it as pay, and anything above that that you need to pay your expenses
00:18:10.040 | has to come from your portfolio,
00:18:12.040 | and then you do an asset allocation on your portfolio to give you that extra income.
00:18:16.040 | So that's the way I look at it.
00:18:20.040 | Thank you.
00:18:22.040 | We have a question from Lady Geek for Bill Barnstein and Rick Ferry.
00:18:27.040 | Although the risk of bonds and stocks are very different,
00:18:30.040 | investors sometimes associate a high-yield bond with an equivalent equity portfolio.
00:18:37.040 | What is the role of high-yield bonds in a portfolio?
00:18:41.040 | A brief introduction for new investors would be appreciated.
00:18:45.040 | That was from Bill Barnstein and Rick Ferry.
00:18:48.040 | Go ahead, Bill.
00:18:50.040 | I will, yes.
00:18:54.040 | A high-yield bond you can think of as being a mix of mostly high-quality bonds
00:19:02.040 | and a little bit of stock.
00:19:06.040 | So the only thing I would say about high-yield bonds is don't count on it
00:19:11.040 | when the excrement hits the ventilating system because you're going to have to take a haircut.
00:19:18.040 | That's why I really, except in very exceptional circumstances, don't like high-yield bonds
00:19:24.040 | because I believe that they're risky assets, they're safe assets.
00:19:28.040 | Don't confuse the two.
00:19:30.040 | The high-yield bond is halfway in between.
00:19:32.040 | There's a correlation with that, and I just find it very aesthetically displeasing for that reason.
00:19:37.040 | If you want to own high-yield bonds, own T-bills, own a little bit of stocks.
00:19:42.040 | You've got the same thing, plus you'll sleep better at night.
00:19:46.040 | I disagree.
00:19:49.040 | Okay, so a high-yield bond market wouldn't exist if it was inefficient,
00:19:54.040 | and the argument is a high-yield is inefficient.
00:19:56.040 | It acts like equity. It's like a bond.
00:19:58.040 | It's an inefficient market.
00:20:00.040 | It shouldn't exist, yet it keeps getting bigger and bigger and bigger every year,
00:20:03.040 | and the issuance of high-yield bonds keeps getting absorbed.
00:20:08.040 | I did a lot of work in separating the credit risk of high-yield bonds from the default risk.
00:20:15.040 | With corporate bonds, investment-grade corporate bonds, you have credit risk,
00:20:19.040 | and what that is is the possibility of the bond credit degrading down to high yield.
00:20:25.040 | When you get to high yield, you can actually separate out the credit risk from another type of risk
00:20:30.040 | that only shows up in high yield, and that's the default risk.
00:20:33.040 | I actually stripped out default risk from credit risk,
00:20:36.040 | and then I did a correlation of the default risk to equity risk
00:20:41.040 | to see if, in fact, default risk and equity risk are the exact same risk.
00:20:47.040 | The answer is, at times it is, and at times it isn't.
00:20:51.040 | So the default risk is actually a unique risk to high-yield bonds.
00:20:56.040 | To the extent that I look at portfolio management as a diversification of risks,
00:21:00.040 | if I have this unique risk in high-yield bonds, and it's a big market out there,
00:21:05.040 | and it's a relatively efficient market,
00:21:07.040 | I want to include at least a slice of that in my clients' portfolios
00:21:11.040 | to actually make the portfolio a little bit more efficient as a portfolio.
00:21:15.040 | So I just look at it a little differently.
00:21:17.040 | Well, I'd like to add, too, that while a question may be directed to a specific individual
00:21:23.040 | or two individuals, as in this case, that after they address the question,
00:21:29.040 | if the other panelists have any thoughts they'd like to add, please do.
00:21:33.040 | If I could just add one thing, and I do agree with Bill on this one.
00:21:38.040 | You could make the argument that variable annuities and hedge-funded funds wouldn't exist
00:21:42.040 | if there weren't a market for it, but they're sold.
00:21:44.040 | It doesn't mean that it's inefficient.
00:21:47.040 | [laughter]
00:21:50.040 | And I think you take your risk with equities,
00:21:53.040 | and you want your fixed income to be the shock absorber, the ballast.
00:21:56.040 | I'm not even in agreement with over-weighting investment-grade corporate
00:22:02.040 | in a total bond portfolio with BND.
00:22:07.040 | You know, I mentioned earlier that I like thinking of theory first
00:22:11.040 | and figuring out how that applies in practice.
00:22:14.040 | Theoretically, a stock is essentially a call option, and the strike price is the value of the bond.
00:22:21.040 | So it's a call on the value of the firm, but the strike price is the value of all fixed income assets.
00:22:28.040 | And so whether it's a high yield or creditworthy, it is the strike price.
00:22:37.040 | And note that the strike price there is almost by definition a little bit closer to the edge
00:22:48.040 | than it would be for a high-credit quality bond.
00:22:52.040 | So I guess I've always kind of thought of it as a little bit of a hybrid.
00:22:57.040 | I tend to think of things linearly, I guess.
00:23:00.040 | If I think of this as the value of the firm, and this is the strike price or the value of the bonds,
00:23:06.040 | and this is the value of the equity, in a high-yield bond or high-yield situation,
00:23:14.040 | the strike price is closer to the edge of the value of the firm,
00:23:19.040 | and therefore I think does take on some characteristics of the equity market as well.
00:23:24.040 | It's kind of a hybrid between fixed income and equity.
00:23:34.040 | If you look at the performance of the Vanguard high-yield corporate bond fund over the last five years,
00:23:39.040 | it has outperformed both bonds and equity.
00:23:43.040 | How can it do that if it's a hybrid between bonds and equity? I don't understand.
00:23:47.040 | But I'll just leave it there. We can go to the next question now.
00:23:56.040 | Well, because it's basically a low-beta equity combination,
00:24:01.040 | and when you go through a very significant bear market,
00:24:04.040 | it doesn't take the same degree of hit that the -- it wasn't down 55% the way the equity market was.
00:24:10.040 | Let me just add one more thing.
00:24:14.040 | Whatever one thinks about the general principle,
00:24:16.040 | don't make the mistake of thinking high-yield bonds are a commodity.
00:24:19.040 | They're all alike. There are staggering differences in quality.
00:24:23.040 | Vanguard, because of our policy and low cost,
00:24:26.040 | we can deliver the same yields that somebody that wants to deliver extra yield with a high expense ratio,
00:24:31.040 | has to have a much lower -- a much riskier portfolio.
00:24:36.040 | So there's a big selection risk in high-yield bond funds,
00:24:40.040 | but you want to be very, very careful in that. They're all different.
00:24:43.040 | This next question is very interesting, and, Jack, I think we'll start with you on this,
00:24:48.040 | and we'll go straight down the line.
00:24:50.040 | It says, "Question for all the panelists. What was or is your most humbling investment experience,
00:24:56.040 | and what have you learned from it?"
00:25:03.040 | Well, when I was young and out of college, just out of college, maybe the first five, seven years,
00:25:11.040 | many of my friends were in the brokerage business, and they always had a great stock for me.
00:25:16.040 | And I don't know how to differentiate.
00:25:19.040 | I would say every single one of the damn things was a humbling experience.
00:25:24.040 | And one of them was in the original Windsor fund run by a guy named Bob Kenmore,
00:25:29.040 | and I can't remember the name of it, some kind of computer thing.
00:25:34.040 | And Kenmore loved it. He had it in the fund.
00:25:37.040 | So he talked me into buying it when I did stocks.
00:25:40.040 | I haven't done stocks for, I guess, 40 years, something like that.
00:25:44.040 | And I did, and, of course, that failed like all the rest of them.
00:25:47.040 | So the humility you get by not just buying stocks,
00:25:54.040 | by buying stocks that are recommended with all due deference,
00:25:57.040 | but that are recommended by brokers, is just, is this thing hazardous duty squared.
00:26:05.040 | Okay, I'll give you two.
00:26:08.040 | One of them was when I was in the Marine Corps, and I finally started to accumulate some money.
00:26:13.040 | And I bought a very popular financial magazine that you all know, but I won't mention the name.
00:26:19.040 | And in there I recommended three great stocks for the future.
00:26:23.040 | And I bought $500 worth of each of these three stocks.
00:26:28.040 | And within two years, all three were bankrupt.
00:26:32.040 | The second one was I was on vacation again in the Marine Corps with a young family,
00:26:36.040 | and I walked into an art shop in Honolulu, Hawaii.
00:26:42.040 | And I saw these dolly prints on the wall.
00:26:47.040 | And I just thought that, and I was talked into the fact that these are the greatest investments in sliced bread.
00:26:52.040 | And so I bought one.
00:26:54.040 | That was my other second worst investment, because it turned out to be a fake dolly.
00:26:58.040 | [laughter]
00:27:01.040 | I guess I'll give two quick ones as well.
00:27:04.040 | Back in 1983, I was at a conference.
00:27:08.040 | I started a gold mining company.
00:27:12.040 | I put a venture capital deal together to start a gold mining company.
00:27:15.040 | And so I was at an investment conference, and Milton Friedman was talking at that conference.
00:27:20.040 | Well, Milton Friedman had a student named Colin Campbell who was a professor of mine.
00:27:25.040 | So I went up to him and asked, "Do you still keep in touch with Colin Campbell?"
00:27:30.040 | And so he said, "You know Colin?"
00:27:33.040 | He said, "Yeah, he's a professor of mine."
00:27:34.040 | He said, "Oh, you're my grandson."
00:27:35.040 | So he's yelling out to people, "He's my grandson."
00:27:38.040 | So he asked me, he said, "So what do you do now?"
00:27:40.040 | I said, "Well, I put a venture capital deal together to start a gold mine."
00:27:43.040 | He says, "Oh, so you're unemployed."
00:27:45.040 | [laughter]
00:27:51.040 | The other one was, I think you may remember this one.
00:27:54.040 | I was actually going out for my interview with Vanguard in September of 1987.
00:27:59.040 | I was interviewing with Jeremy Duffield, who actually ended up hiring me.
00:28:03.040 | Jeremy said, "It was a Saturday."
00:28:05.040 | He said, "So come in, kind of golf attire, something casual but reasonable."
00:28:11.040 | And so it turned out that Friday the day before, I was with my wife.
00:28:16.040 | Her company was doing an outing, and so I was with them.
00:28:19.040 | I was wearing, actually, basketball shoes.
00:28:23.040 | I was in the airplane.
00:28:24.040 | I went right from there to the airplane.
00:28:26.040 | I was in the airplane flying out here for the interview.
00:28:29.040 | I realized the only shoes I had were basketball shoes.
00:28:33.040 | [laughter]
00:28:34.040 | And it was 10 o'clock at night by the time I got here.
00:28:36.040 | So I interviewed with Jack wearing basketball shoes.
00:28:40.040 | [laughter]
00:28:43.040 | I'm not sure I noticed.
00:28:44.040 | [laughter]
00:28:47.040 | Well, before I was 40, I probably made every dumb mistake that everyone else in this room has made.
00:28:53.040 | But I think that the biggest mistake I've made in my professional life
00:28:57.040 | was not understanding what Warren Buffett has understood most of his life,
00:29:01.040 | which is the only safe asset in this world are short-term treasury securities.
00:29:06.040 | And during the crisis, that really didn't come home to me.
00:29:11.040 | And I realized that even short-term corporates, even short-term municipal bonds,
00:29:16.040 | are going to incur a haircut if you want to cash them in to live on or buy even cheaper stocks.
00:29:25.040 | I used to be much smarter than I am now.
00:29:27.040 | I took my college graduation money in 1979, about a year later, and put it in gold.
00:29:35.040 | Gold had fallen back from $8.50 to $6.64 an ounce,
00:29:38.040 | and I was absolutely sure it was going to double every year.
00:29:43.040 | Now, obviously, it hasn't even kept up to inflation.
00:29:46.040 | If I had discovered the Jack Bogle and put it in an index fund,
00:29:51.040 | I would have had a whole heck of a lot more money.
00:29:54.040 | It taught me I wasn't as smart as I thought I was.
00:29:57.040 | And my only excuse is Richard Thaler had not invented behavioral finance,
00:30:01.040 | so I did not know I was following him.
00:30:03.040 | It's not your fault.
00:30:05.040 | Innocent victim here.
00:30:07.040 | You're a victim.
00:30:08.040 | Well, since it's true confession time, I'll throw mine in, too.
00:30:11.040 | I started investing in the late '60s, and every magazine article that I read about a fund,
00:30:19.040 | I never met a fund that I didn't like and didn't buy.
00:30:23.040 | And I was really reminded a couple of years ago, well, in 2006, we sold our home,
00:30:30.040 | and in the attic was boxes of all the funds that I used to own back in the days before
00:30:39.040 | down Vanguard and investing in that.
00:30:42.040 | So I was really reminded of the things that we all go through, or most of us go through,
00:30:49.040 | early in our investing career, and that's we just follow all the hot funds,
00:30:54.040 | we do performance chasing, we do everything wrong.
00:30:58.040 | Hopefully the forum helps a lot of people from making those same mistakes that we make.
00:31:04.040 | So that's one of the reasons we all do what we do,
00:31:07.040 | to try to keep people from making the same mistakes that we make.
00:31:12.040 | Here's a question for Alan.
00:31:15.040 | With the interest rates at an all-time low, where does one get income?
00:31:20.040 | Hmm. How do you go box?
00:31:25.040 | Oh, I'm sorry, I spoke out of turn.
00:31:28.040 | I'll go with Rick. Let's make it feel good.
00:31:32.040 | You know, I reject the fact that rates are near an all-time low now.
00:31:37.040 | If we go back to 1981, you could earn 12% on a CD,
00:31:42.040 | which meant that after taxes, rates were much higher than you got, about 8%.
00:31:47.040 | Inflation was as high as 15%, so you were 7 percentage points worse off.
00:31:54.040 | It felt good because you got to see the statement increase.
00:31:58.040 | So, you know, I tell people that, I tell my clients,
00:32:03.040 | our portfolio is stored energy that allows us to do what we want with our life,
00:32:08.040 | and you can't take it with you, and it's okay to spend down the principle,
00:32:13.040 | quit looking for income.
00:32:16.040 | Everyone in this room, for one reason or another,
00:32:19.040 | was programmed to put money away, to be accumulators,
00:32:23.040 | and it's very difficult to give yourself permission to spend it down.
00:32:28.040 | So I don't know what rates are going to do,
00:32:30.040 | and there may be a reversion to the mean,
00:32:32.040 | and I use certain CDs that have easy early withdrawal penalties
00:32:36.040 | as a put, the right to sell it back to the bank if interest rates do increase,
00:32:41.040 | but quit chasing income would be my number one recommendation.
00:32:45.040 | And by the way, stocks are yielding 5.1%, 3.1% in terms of a stock buyback,
00:32:52.040 | which is absolutely returning cash to shareholders,
00:32:55.040 | and another 2% in dividends.
00:32:57.040 | So the income really needs to come from the equity portion of your portfolio.
00:33:03.040 | I mean, return is return.
00:33:06.040 | It doesn't matter whether it comes from capital return or dividends.
00:33:10.040 | To me, the whole thing of looking for investment income to live on
00:33:14.040 | is an oxymoron.
00:33:16.040 | And I'll second what Alan says, is you're accumulators.
00:33:19.040 | Don't be afraid to spend a little of that capital
00:33:21.040 | and maybe fly first class once in a while.
00:33:25.040 | And that's actually Vanguard's position as well,
00:33:28.040 | that we think of total return investing as opposed to thinking of yield.
00:33:32.040 | It's really what is the total return,
00:33:35.040 | and then you use whatever you need to in capital in addition to the yield.
00:33:40.040 | So we talked earlier about high dividend yielding stocks.
00:33:44.040 | Let's say you get a 4% dividend yielding equity,
00:33:47.040 | and just for hypothetical reasons say, well,
00:33:50.040 | you're going to get 6% capital appreciation.
00:33:52.040 | Is that any better than a 2% yielding equity with an 8% capital appreciation?
00:33:56.040 | In fact, you could argue that it depends on the tax environment,
00:34:00.040 | but it could be worse.
00:34:02.040 | In the old days when dividends were taxed at ordinary rates,
00:34:05.040 | you'd actually rather get capital gains.
00:34:08.040 | But the advantage of thinking total return is you end up with a more broadly diversified portfolio,
00:34:13.040 | and you're not taking the factor bets that you might with a high dividend yielding portfolio.
00:34:21.040 | I'm just going to agree with Bill and Alan.
00:34:24.040 | I do like Alan's idea of that a buyback yield is a real cash yield.
00:34:31.040 | They're using the cash instead of the pay you.
00:34:33.040 | In a cash dividend, they're using the cash to buy back stocks,
00:34:36.040 | so why not sell that portion of the stock market,
00:34:40.040 | that 3% or so, that's the buyback yield.
00:34:45.040 | You could take that as income as well.
00:34:47.040 | So I'm on board with everybody so far that it's the total return of the portfolio that matters.
00:34:52.040 | We have a question for Gus.
00:35:00.040 | You mentioned that PE is the best predictor of equity returns.
00:35:04.040 | You also hammered that beta timing is a fool's game.
00:35:09.040 | Should investors shift or tilt their equity on exposure based on current PE ratios?
00:35:15.040 | Gus mentioned that PE is the best predictor of equity returns.
00:35:23.040 | He also said that beta timing is a fool's game.
00:35:27.040 | Should investors shift or tilt their equity bond exposure based on current PE ratios?
00:35:33.040 | Well, I think PE ratios are actually pretty fair right now.
00:35:40.040 | I mentioned earlier, Vanguard's econometric model is predicting 6 to 9% equity returns,
00:35:48.040 | which I think is a fine return if we should get a return in that segment.
00:35:53.040 | I think if you look at Shiller PEs, people say, "Well, Shiller PEs are still quite high."
00:35:57.040 | I think in normal times, Shiller PEs are fine.
00:36:00.040 | I think today's Shiller PEs are distorted.
00:36:03.040 | They're backward looking.
00:36:04.040 | We know that the market's forward looking.
00:36:06.040 | A Shiller PE usually works okay.
00:36:10.040 | It's just a way to normalize earnings.
00:36:13.040 | It's going to produce a higher PE ratio than you would using, say, the last 12 months of forward looking.
00:36:18.040 | You just have to calibrate it and recognize it's, on average, going to be higher and compare it to its longer term average.
00:36:24.040 | Right now, it's distorted because of the last 10 years.
00:36:27.040 | We've just seen earnings do crazy things over the last 10 years.
00:36:30.040 | Actually using last 12 months would be better than a Shiller PE, and actually forward looking PEs are better than last 12 months
00:36:37.040 | because the market's clearly forward looking.
00:36:40.040 | From that standpoint, I think things are fair.
00:36:43.040 | Maybe we're slightly above long term average.
00:36:47.040 | That's typically not where bull markets end.
00:36:50.040 | But if you look out over 10 years, you should get a reasonable rate of return,
00:36:53.040 | maybe a little bit less than historical averages.
00:36:56.040 | As I indicated in my one presentation, even though I think there will be reasonable returns in the equity market,
00:37:06.040 | I still question the idea of throwing caution to the wind and over-investing in equities
00:37:13.040 | because you are taking greater risk.
00:37:16.040 | Bonds are there to moderate your portfolio risk.
00:37:20.040 | I believe what I showed with the efficient frontier and the utility curves, with lower expected returns both in equities and bonds,
00:37:27.040 | even though equities are reasonable, it still looks like a static asset allocation, not necessarily a shift to a new asset allocation.
00:37:38.040 | I wouldn't necessarily say move to equities.
00:37:44.040 | I think staying with your long term strategic asset allocation makes a lot of sense.
00:37:51.040 | Gus, could I just ask you, do you use operating earnings or reported earnings to calculate your PE?
00:37:56.040 | Do you look at the past 12 months or the next 12 months?
00:37:59.040 | Typically we look at the next 12 months and look at operating earnings.
00:38:05.040 | Isn't that kind of a cop out?
00:38:23.040 | Fifteen years ago, when Jeff was running the ship, I would have said, yeah, it's a cop out.
00:38:31.040 | It's just a way of calibrating things.
00:38:34.040 | Because then you compare things historically.
00:38:37.040 | The important thing is comparing apples to apples.
00:38:41.040 | So Shiller is okay if you compare Shiller to Shiller.
00:38:45.040 | You wouldn't compare Shiller and say, well, Shiller's PE ratio is 20 times and the long term average is 15.
00:38:51.040 | It's just important to compare apples to apples.
00:38:55.040 | I think that the best long term work on this has been done by Dimson, Marsh, and Staunton.
00:39:01.040 | And you can get it for free.
00:39:03.040 | It's $710 for Triumph of the Optimist.
00:39:06.040 | But their Credit Suisse yearbooks are available online for free.
00:39:09.040 | I know they discussed on the board.
00:39:12.040 | And what we're really talking about here is torquing around your equity allocation based on the valuation.
00:39:18.040 | And in just about all 20 countries they looked at over the course of the 20th century, that was a monk's game.
00:39:24.040 | You did not gain any risk adjusted returns by doing that.
00:39:28.040 | However, what they found was that by adjusting your internal allocations among nations, depending upon which countries were cheap,
00:39:37.040 | that did improve risk adjusted returns.
00:39:41.040 | So how do you apply that now?
00:39:43.040 | Well, as you look around the world today, I think that U.S. equities are probably the most expensive.
00:39:47.040 | I think developed market equities are probably a little less expensive.
00:39:51.040 | And for a very good reason I know that.
00:39:53.040 | And emerging markets of late have perhaps even become cheaper than developed market stocks,
00:40:01.040 | as I think someone mentioned last night.
00:40:05.040 | So, you know, you can take that for what it's worth.
00:40:09.040 | And if you want to play that game, you can play that game.
00:40:11.040 | But if you don't want to, you'll do just fine as well.
00:40:14.040 | I knew that was the reason I was overweighted in emerging markets.
00:40:18.040 | That's it. That's not advice.
00:40:21.040 | I think sticking with an asset allocation is more important than picking it right in the first place.
00:40:27.040 | We've seen all sorts of data presented last night throughout that the dollar-weighted returns way underperform fund-weighted returns.
00:40:35.040 | We have all of these sophisticated reasons to change our asset allocation, and they typically lead to lower returns.
00:40:42.040 | So sell equities because equities are up to get back to your target allocation.
00:40:47.040 | So you're not going to be coming out with the Allen Roth under fund flow ETF?
00:40:54.040 | Now that got turned down by Gus.
00:40:58.040 | I think that valuations are important as you're getting close to retirement,
00:41:07.040 | as the amount of money that you have accumulated reaches your goal,
00:41:12.040 | and you're going to be doing an asset allocation shift down anyway
00:41:18.040 | because you've accumulated the amount of money that you need for retirement,
00:41:22.040 | and the risk then is to lose it.
00:41:24.040 | So you don't need to take as much risk.
00:41:26.040 | The question is when do you actually make this shift?
00:41:29.040 | If it's 2008, early 2009, and the P/E of the market is down around 10,
00:41:35.040 | I just wouldn't recommend making the shift then.
00:41:38.040 | I would wait until the market came back to 15 P/E or so.
00:41:43.040 | On the other hand, if the market is trading at 35 times earnings or 30 times earnings like it was in 1999,
00:41:49.040 | and you've made a lot of money because of the increase in the speculative premium,
00:41:54.040 | as Jack would call it in his books,
00:41:56.040 | and you've made a lot of money and you're at your goal,
00:42:01.040 | then you might want to do an asset allocation shift a little early.
00:42:05.040 | But that's probably the only time.
00:42:07.040 | If you're 25, 30 years old and your time horizon on taking your money is 20, 30 years out,
00:42:12.040 | I don't think you need to worry about valuations.
00:42:14.040 | I will say one more thing, and that is that Bill made the comment
00:42:17.040 | that we should perhaps look at the valuations of different countries.
00:42:22.040 | And I think that if you divide your portfolio up among U.S. equities,
00:42:28.040 | developed markets, and emerging markets and have a fixed allocation
00:42:32.040 | and then do a rebalancing, say, once a year,
00:42:35.040 | that you're actually going to take advantage of what Bill was talking about
00:42:37.040 | and not have to work too much on it.
00:42:42.040 | The next question is for everyone.
00:42:44.040 | Bonds, it's about bonds.
00:42:46.040 | What do you do with dollars set to go into bond index funds?
00:42:50.040 | I guess this is a nervous investor who is afraid to put the money that's allocated for bond funds
00:42:59.040 | to invest it at this time.
00:43:03.040 | The question is, what do you do with it?
00:43:05.040 | What do you do with it?
00:43:07.040 | You invest it.
00:43:12.040 | Again, the role bonds play, it's never been what we think is the workhorse in a portfolio.
00:43:17.040 | It has a role as a diversifier to moderate the volatility that we experience in our portfolio.
00:43:23.040 | And that role hasn't changed.
00:43:25.040 | The good news is if interest rates start to rise,
00:43:30.040 | the equity portion of your portfolio is likely to perform pretty well.
00:43:33.040 | My view of the way things unfold is that the economy starts to get a little bit stronger,
00:43:41.040 | the Fed backs off, it tapers, interest rates rise,
00:43:45.040 | but the equity market does pretty well in that environment.
00:43:47.040 | There's a difference between tapering and tightening.
00:43:50.040 | So, like Rick, I'd say stick with your strategic asset allocation
00:43:54.040 | and go ahead and make the investment and just recognize that it's there for a reason.
00:43:59.040 | I mean, you know, what if an accident happens?
00:44:02.040 | I mean, what if Congress does something crazy?
00:44:05.040 | Imagine that right now.
00:44:10.040 | Well, I guess the follow-up question on that would be,
00:44:14.040 | do you lump sum it or dollar a cost average when you're a real nervous investor?
00:44:19.040 | I'd say just do it.
00:44:21.040 | I think there's a lot of arrogance in the belief that, you know,
00:44:24.040 | common wisdom is that quantitative easing has to end,
00:44:29.040 | which is going to cause rates to go up.
00:44:31.040 | I think there's arrogance in saying the market didn't know
00:44:34.040 | that we couldn't buy back our treasuries indefinitely,
00:44:37.040 | and we don't know what's going to happen to rates.
00:44:40.040 | The top economists have been directionally correct on longer-term rates,
00:44:43.040 | far less than a coin flip.
00:44:45.040 | So just do it, in my opinion.
00:44:51.040 | This one's for Rick and others.
00:44:53.040 | We've already heard from Gus and Jack spoke briefly on this.
00:44:59.040 | But, Rick and the others, what are your thoughts on smart beta?
00:45:04.040 | [Laughter]
00:45:07.040 | Oh, okay.
00:45:09.040 | So, lowly investment advisor, I don't know these things,
00:45:13.040 | so I called up the--or actually emailed the experts.
00:45:16.040 | I got an opinion from Bill Sharp, Nobel laureate Bill Sharp.
00:45:19.040 | I got an opinion from now Nobel laureate Gene Fama.
00:45:22.040 | I got an opinion from Ken French.
00:45:26.040 | And I got an opinion from my friend Rob Arnott, who is a friend of mine, by the way.
00:45:30.040 | [Laughter]
00:45:32.040 | Okay, so three out of four of them said there is no such thing as smart beta.
00:45:35.040 | [Laughter]
00:45:37.040 | And guess which one said there was?
00:45:39.040 | [Laughter]
00:45:41.040 | Yeah, so basically, I think that Gene Fama summed it up the best.
00:45:45.040 | He basically said that if you look at value versus growth and small cap versus large cap,
00:45:54.040 | and you do regressions on these returns, the regressions are positive,
00:45:59.040 | which means you could call it a beta, and some people do.
00:46:04.040 | He doesn't call it a beta.
00:46:06.040 | Fama doesn't call it a beta.
00:46:09.040 | Bill Sharp doesn't call it a beta.
00:46:11.040 | He says, but some people in academics mathematically would call that excess return premium
00:46:17.040 | that we've seen in the market a beta.
00:46:20.040 | And therefore, if you put additional betas in your portfolio in addition to the market,
00:46:27.040 | it becomes a multi-factor portfolio.
00:46:30.040 | But there is no such thing as smart beta.
00:46:33.040 | It's silly to call it smart beta.
00:46:35.040 | Beta is just beta.
00:46:37.040 | But you could call it additional betas.
00:46:41.040 | So that's the right term to use, additional betas.
00:46:46.040 | The most difficult piece I've ever had to write is about a five,
00:46:50.040 | six hundred word piece for a financial planning magazine in the current issue
00:46:54.040 | where I had to give the Portfolio Innovator Award to Rob Arnott.
00:46:58.040 | [Laughter]
00:47:00.040 | And it is an innovation.
00:47:02.040 | It's certainly the small cap value tilting, and I tend to get small cap value tilting from my client
00:47:09.040 | by buying a total stock index and a little bit of a small cap value vanguard index.
00:47:15.040 | But it's an innovation when you capture 100 million one way or the other.
00:47:19.040 | I believe it's more of a marketing innovation.
00:47:24.040 | And it is a new way, as Rick Perry pointed out, of allowing individuals to capture that small cap beta
00:47:32.040 | directly outside of DFA, which you have to go through advisors.
00:47:38.040 | It's a buzz word.
00:47:41.040 | It's like fundamental indexing.
00:47:44.040 | I don't believe I'm going after dumb beta.
00:47:47.040 | [Laughter]
00:47:48.040 | That was the biggest thing, by the way.
00:47:50.040 | I really took offense to what Rob was calling.
00:47:52.040 | I did not come up with the term smart beta.
00:47:54.040 | Somebody else came up with it, but he just embraced it.
00:47:56.040 | He patented it anyway.
00:47:58.040 | [Laughter]
00:48:00.040 | I was at a conference last week, and Rob was speaking, and the presentation of his speech was smart beta.
00:48:07.040 | And he must have said the term 100 times in 40 minutes.
00:48:10.040 | It was just driving me crazy.
00:48:12.040 | But I think the thing that really turns me about smart beta that I don't like is it infers that all of us
00:48:19.040 | market investors are investing in dumb beta, which makes us all dumb.
00:48:24.040 | And that's what I really don't like about it.
00:48:26.040 | Jack, how do you feel about that?
00:48:28.040 | I agree.
00:48:29.040 | [Laughter]
00:48:31.040 | I actually think it's misleading.
00:48:34.040 | The ads say this has outperformed the S&P 500.
00:48:38.040 | Why in the world would you compare a mid-cap value portfolio to the S&P 500?
00:48:42.040 | I mean, our mid-cap value index fund has outperformed the S&P 500, but we don't market that.
00:48:48.040 | So I think it's potentially drawing people into an investment without really realizing what they're getting.
00:48:54.040 | Gus, this next one's for you.
00:48:58.040 | It said, "Could you please explain how you managed to keep the index fund returns so close to the benchmark returns
00:49:06.040 | despite transaction costs and cash drag?"
00:49:10.040 | Is it all about securities lending?
00:49:12.040 | What is your secret sauce exactly?
00:49:14.040 | [Laughter]
00:49:16.040 | What is your secret of secret sauce?
00:49:18.040 | [Laughter]
00:49:20.040 | I see Karen D'Amato over there.
00:49:22.040 | [Laughter]
00:49:25.040 | You know, indexing is a lot of blocking and tackling.
00:49:28.040 | It's about this much intellectual property and a ton of blocking and tackling.
00:49:33.040 | And I think we've got the best traders in the industry.
00:49:37.040 | They've been with us for as long as--the first one who joined me in 1989 is there today.
00:49:45.040 | They're phenomenal at what they do.
00:49:48.040 | They identify, I'll say, micro-inefficiencies and can add some value.
00:49:54.040 | One thing we have is an advantage of size.
00:49:57.040 | And continually going into the marketplace, we can find opportunities that, you know,
00:50:04.040 | if you're not continually going into the marketplace, you don't have the opportunity to take advantage of it.
00:50:08.040 | So, you know, a lot of it is just being great traders, minimizing transaction costs,
00:50:16.040 | and looking for these micro-opportunities.
00:50:19.040 | In some funds--the question is also, is it securities lending?
00:50:24.040 | In some funds, they are enhanced by securities lending.
00:50:28.040 | In the small cap fund or an international fund, in any given year,
00:50:32.040 | it may be as high as 10 basis points of additional return.
00:50:36.040 | In a lot of funds, though, it's a basis point.
00:50:39.040 | In the S&P 500 large cap segment, it's negligible.
00:50:44.040 | It's not even measurable.
00:50:46.040 | So it's mostly the skill and expertise of our index team.
00:50:53.040 | So Rick Edelman isn't right about hiding 2% in trading costs.
00:50:58.040 | Actually, you underperform the index by less than the expense ratio, which I think is--
00:51:04.040 | Phenomenal.
00:51:05.040 | --yeah, absolutely amazing what you've done for shareholders.
00:51:08.040 | You really have.
00:51:09.040 | It's amazing.
00:51:10.040 | Thank you.
00:51:11.040 | [Applause]
00:51:17.040 | Okay, let's move to tips now.
00:51:19.040 | We have a couple of questions.
00:51:21.040 | The first one is from Victoria.
00:51:23.040 | Please discuss at what level of fixed rates it will become advantageous to start buying tips again.
00:51:30.040 | And the follow-up question or associated question is,
00:51:34.040 | what are the panel's views on tips and their role in a portfolio
00:51:38.040 | in the current interest rate and inflation environment?
00:51:42.040 | So can we cover the broad tips market then, please?
00:51:48.040 | Well, I always have tips in a portfolio because of the reason they exist,
00:51:52.040 | and that is as a hedge against unanticipated inflation.
00:51:55.040 | And since unanticipated inflation is a risk in the portfolio,
00:51:59.040 | then I always want to have a small portion of my bond portfolio in tips,
00:52:04.040 | and my allocation has always been 20%, and it's worked out fine for me.
00:52:10.040 | I've been nervous about tips the last several years because real rates have gone negative.
00:52:14.040 | Historically, real rates on, say, a 10-year tip is 175 basis points, one and three-quarters percent.
00:52:21.040 | They actually went negative, and right now they're still very, very low.
00:52:26.040 | It turns out that the duration on a tips bond,
00:52:31.040 | the real rate duration is actually quite high, like eight years.
00:52:36.040 | So if the real rate reverted back to, say, the longer-term average of one and three-quarters percent,
00:52:42.040 | that's a backup of, let's say, 150 basis points from here,
00:52:45.040 | you could lose 12% in principle trying to capture an inflation premium.
00:52:50.040 | I think this is a point in time where tips really kind of scare me.
00:52:57.040 | With regard to inflation, I've been saying ever since the global financial crisis,
00:53:05.040 | inflation isn't going to happen.
00:53:07.040 | A lot of people are worried that the Fed's balance sheet has just ballooned,
00:53:10.040 | and they're talking about the money supply exploding.
00:53:13.040 | The money supply is not exploding.
00:53:15.040 | The Fed's balance sheet is expanding.
00:53:18.040 | The money multiplier has collapsed.
00:53:21.040 | If you look at the broader aggregates of money supply, they're growing at 5% a year.
00:53:27.040 | That's basically nominal GDP growth, and you need money supply to grow at that level.
00:53:32.040 | If you don't, you're going to start choking off your economy.
00:53:36.040 | So obviously there's so much slack in the economy right now.
00:53:41.040 | I personally just am not worried.
00:53:43.040 | I think Rick's right that tips guard against unanticipated inflation,
00:53:47.040 | against some sort of oil shock or something like that.
00:53:50.040 | If it's anticipated inflation, like you get in the mid-'80s, actually, mid-'70s,
00:53:58.040 | actually equities are a great inflation hedge in that type of environment.
00:54:02.040 | Equities performed great in the second half of the '70s.
00:54:06.040 | Tips are good for unanticipated inflation.
00:54:08.040 | I just think they have some risks at this point.
00:54:12.040 | I think those are all very interesting features of tips, and I agree with what Rick and Gus said.
00:54:19.040 | I see tips as the ultimate liability matching element in everybody's portfolio.
00:54:30.040 | We all have a stream of real liabilities in the future in terms of our retirement,
00:54:35.040 | and a tips ladder that is adjusted and aimed at that is probably the safest asset that you can have.
00:54:42.040 | I think it will ensure your retirement the best.
00:54:45.040 | Having said that, I'll also agree with Gus.
00:54:47.040 | This ain't the time to be buying.
00:54:49.040 | The natural rate of the long tips is probably in excess or at least in the vicinity of 2%.
00:54:55.040 | Shorter tips, 1 to 2%, depending upon the duration.
00:55:00.040 | And at the shorter end, you're still looking at negative yields.
00:55:03.040 | I wouldn't be in a rush to buy them right now.
00:55:07.040 | I'm a hypocrite.
00:55:08.040 | I time the market when it comes to tips quite a bit.
00:55:13.040 | I say tips are the lowest risk asset out there because it's the real return that matters,
00:55:19.040 | and of course the U.S. would never default on it.
00:55:24.040 | By the way, they say that Congress has a 5% approval rating.
00:55:27.040 | I've never met one of those 5%.
00:55:32.040 | They work for Congress.
00:55:34.040 | But anyways, tips are far more volatile than treasuries.
00:55:38.040 | In 2008, when stocks plunged, people ran to traditional treasuries, not to tips,
00:55:44.040 | and those yields were 3.5%.
00:55:46.040 | That was a wonderful time to get into tips.
00:55:49.040 | I still believe that tips need to be part of the portfolio.
00:55:53.040 | They give some protection against inflation, not as much as stocks,
00:55:57.040 | but they are a part of the portfolio.
00:56:00.040 | I just want to mention one more time that if tips are a strategic allocation,
00:56:04.040 | a certain percentage of your bond portfolio, and you're doing rebalancing,
00:56:07.040 | then when they go to 3.5%, you're going to be buying,
00:56:10.040 | and when they go to a deep negative, you're going to be selling because the values have gone up.
00:56:15.040 | So you are capturing a portfolio benefit by just having a fixed allocation in your portfolio.
00:56:23.040 | Gus, if you're scared, I mean, you know investors are worried about tips too,
00:56:31.040 | would you recommend cutting back on tips or just holding for somebody who's got 30%, 40%, 50% of their bond allocation,
00:56:39.040 | a retiree who is worried about inflation and that's the reason they have the enlarged allocation to tips,
00:56:46.040 | would you recommend they cut back on tips?
00:56:48.040 | The tips are down right now, Vanguard's tips fund is down about 6%, 9% this year,
00:56:53.040 | so you would be selling in a down market.
00:56:57.040 | Would you cut back?
00:56:59.040 | Yeah, I think, you know, to Bill's comment that you're kind of immunizing your future liabilities,
00:57:08.040 | I mean, there's a reason it's called fixed income, it's generally fixed income,
00:57:12.040 | but it's inflation-protected fixed income,
00:57:15.040 | so if you can live off of the income itself and you don't really care what's happening to the principal,
00:57:23.040 | a lot of people don't really think that way,
00:57:25.040 | I mean, you know, all of a sudden you lose money in bonds and people sell like mad,
00:57:29.040 | I mean, go back to the beginning of 1987, there was a collapse in the muni market place,
00:57:38.040 | so if you have discipline and you're living off of the income, it's going to be inflation-adjusted income,
00:57:46.040 | which should take care of you, I think it's okay.
00:57:50.040 | If you are at all concerned about the principal, I'm nervous.
00:57:56.040 | Well, obviously, it's very volatile, that's for sure.
00:58:00.040 | Yeah, and I'd be nervous having 40 or 50% in tips.
00:58:04.040 | We have tips in some managed payout funds, but it's a moderate amount, I mean, it's 10%.
00:58:14.040 | Actually, two of the managed payout funds don't have it, and one did.
00:58:20.040 | Gus, this one's probably for you.
00:58:22.040 | Why did Vanguard buy a market-neutral fund?
00:58:25.040 | It almost seems like something interesting to keep the quants from getting bored.
00:58:33.040 | Now, I was actually hired to develop the active quant equity program and was given the indexing side as well.
00:58:39.040 | I mean, if you do active quant, you can do passive quant.
00:58:42.040 | So I built the active quant equity team, and it's been kind of my pet project, my love.
00:58:51.040 | I find it very intellectually stimulating.
00:58:54.040 | The reason I like active quantitative investing is, I think that I mentioned earlier,
00:59:00.040 | there are inefficiencies in the marketplace, and my belief is those efficiencies arise because we all act irrationally.
00:59:08.040 | I mean, you know, we do irrational stuff all the time, so why should we be rational when we invest?
00:59:14.040 | And that's true with a traditional manager as well.
00:59:18.040 | They're going to make irrational decisions at times,
00:59:22.040 | and I like a quantitative form of investing because you create a model based on theory.
00:59:29.040 | You test it to make sure that it worked, and then you just rigorously apply it.
00:59:33.040 | You do not let your emotions take over.
00:59:36.040 | You just use what you think is the right theory.
00:59:41.040 | And in my view, that maximizes the chances that you'll actually be able to add value or find alpha.
00:59:48.040 | And I think if you look at our active quant group, we've had mixed success over the years.
00:59:53.040 | We've had some really good periods and some dramatic underperformance on average.
00:59:59.040 | I think we've added a little bit of value.
01:00:01.040 | And the way I think of a long/short market neutral fund is it's really a volatile money market fund.
01:00:06.040 | It's a money market fund.
01:00:07.040 | The expected return on it should be money market rate of return plus any alpha,
01:00:14.040 | which could be minus alpha if you don't have skills.
01:00:18.040 | So, you know, I would hope that over time we'll be able to actually get a return that is greater than a money market rate of return,
01:00:27.040 | obviously with volatility that you don't experience in money markets.
01:00:32.040 | Phil, this is for you.
01:00:34.040 | Regarding residual living expenses, what do you mean by residual?
01:00:39.040 | Just to go back to the example I had before, which is that if your living expenses are $70,000 a year,
01:00:46.040 | you're getting $30,000 in Social Security, then you've got $40,000 a year of residual expenses.
01:00:53.040 | And just to amplify that a little bit, you should probably have, if you're going to retire, 25 times your residual living expenses.
01:01:01.040 | So that's a million bucks.
01:01:05.040 | This is a question that comes up every time we have a volatile situation.
01:01:11.040 | I've heard the expression many times over the years, "It's different this time."
01:01:15.040 | I've never believed that to be true for a long-term investor.
01:01:20.040 | The current investing environment does seem somewhat unusual with both stock and bond markets hosting significant risk.
01:01:28.040 | My question is, is it really different this time?
01:01:32.040 | No, no, and no.
01:01:34.040 | New paradigms, and this time it's different, will kill you.
01:01:38.040 | And then second of all, I wrote a piece on data that Wilshire provided, the myth of market volatility.
01:01:45.040 | Markets are no more volatile today than they've been over the last 40 years.
01:01:49.040 | In 2008 and 2009, it was an exception, and there are lots of reasons why we think it's more volatile today.
01:01:58.040 | One of those are that the index values are so much higher that a 1% change today is a lot of points.
01:02:06.040 | 30 years ago, it was much smaller.
01:02:09.040 | So markets are no more volatile today, and this time it's different, will kill you.
01:02:14.040 | The only black swans are the history you haven't read.
01:02:23.040 | I don't think the laws of economics change, and therefore things can't be different this time.
01:02:30.040 | Your borrowing costs have to be below your return on equity.
01:02:34.040 | Your GDP is basically related to population growth and increases in productivity.
01:02:40.040 | These universal laws of economics don't change.
01:02:43.040 | So even though the markets may be volatile, it's not different this time.
01:02:48.040 | All right, we're coming up to the close.
01:02:51.040 | Rick has to catch a flight.
01:02:53.040 | We're on schedule.
01:02:54.040 | We're going to take a break.
01:02:56.040 | I'd like to thank all the panel members who are with us.
01:03:20.040 | Jack has one final message for us.
01:03:24.040 | In my little litany of thanks to everybody, I have, shockingly and embarrassingly,
01:03:31.040 | I didn't mention Mel's leadership, and so I'd like to express my own appreciation for Mel's leadership.
01:03:38.040 | I know you all feel the same way.
01:03:40.040 | The ball stops somewhere, right now and right here.
01:03:43.040 | It's Mel.
01:03:45.040 | [Applause]